Buy Small-Company Stocks Now? - Brief Article

Kiplinger's Personal Finance Magazine, Jan, 1999 by Robert Frick

A verse in every investor's mantra is (repeat after us), "Small-company stocks outperform big-company stocks over time." But you may be tired of humming that tune. On average, big stocks have licked the little guys by a whopping six percentage points a year for the past 15 years. And the data upon which the mantra is based has been severely challenged lately, shaking the faith of true believers. But even if this small-company phenomenon isn't all that valid, right now may be one of those times when owning a hefty chunk of small-company stocks may pay off.

One keeper of the small-company faith is Ibbotson Associates, the Chicago financial firm whose data is often quoted as proving that since 1926 small-company stocks have outperformed large-company stocks by an average of two percentage points a year (and very, very small companies--the so-called micro caps--outperform large stocks by more than three percentage points per year). Because of small-company stocks' sad performance in recent years, Ibbotson has found itself defending these numbers "rather frequently," says senior consultant Dominic Falaschetti, who adds that Ibbotson stands by its numbers.

SCREAMERS. The small-small end of the spectrum has been especially savaged. James O'Shaughnessy, a Greenwich, Conn., money manager and author, makes a credible case that while tiny stocks (with market capitalizations of less than $25 million) look good on paper, you can't make any money on them because they're too hard to buy and sell. In fact, the spread between the buy and sell prices is often 100%, which to a portfolio manager trying to make a buck is "scarier than Scream and Scream II," says O'Shaughnessy.

David Dreman--contrarian guru, author and fund manager--doesn't buy any piece of the small-stock story. He argues that much of the historical data is based

on a handful of blockbuster years that shouldn't be counted--for example, in the 1930s, when what passed for small-company stocks were really stocks of big corporations that had been flattened by the Great Depression.

But given all that, there are several compelling reasons to include small-company stocks or funds in your portfolio today (see "Rebound Time on Wall Street," on page 74). First, because small-company stocks tend not to rise and fall in tandem with big-company stocks, they make your portfolio less volatile. Second, small stocks are like 17-year locusts. As Dreman says, they pack much of their return into a few stellar years, then go dormant. Since 1950, the annualized gain during these two-to-four-year bursts is 39%, says Joe Stallings of Balentine & Co., an Atlanta financial-advisory firm. When small-company stocks do begin their bull-market cycle, he says, "you had better have your ticket punched before the train leaves the station."

REVVING UP. Third, evidence is mounting that one of those sporadic cycles is about to begin--or perhaps already has. The average price-earnings ratio of small-company stocks has now fallen to about the same level as that of large-company stocks. The previous two times that occurred, in 1979 and 1990, the Russell 2000 index of small-company stocks gained 40% or better. Also, such key ratios as price to sales and price to book value show small stocks at historically cheap prices compared with big stocks. Plus, earnings growth of small companies is rising even as earnings growth of big companies is falling.

Finally, consider this powerful contrarian indicator: The typical 401(k) account has less than 2% in small stocks, versus 25% in large stocks.

All aboard!

32 A constellation of new companies is going after local telephone business. But their stocks are volatile.

34 Seven stellar funds that had been closed to new investors have reopened their doors.

42 Mutual Series funds have new masters--and new missions--after the departure of Michael Price.

WWW

A ONE-STOP SOURCE for reams of online information about stocks and mutual funds is at www.justquotes.com. Punch in a stock or fund name and you're presented with several pages of links to other Web sites. The screen is broken up into areas dealing with quotes, charts, analysts' recommendations, earnings, corporate profiles, financial statements, insider information, financial ratios and SEC filings.